Using Retirement Accounts to Fund a Business Startup Draws IRS Scrutiny

The IRS is increasing scrutiny into a complex practice for using retirement accounts to fund a business. The practice may trip up business owners who take advantage of it. In the end, it could cost them not only their retirement nest eggs, but open them up to paying back taxes and large penalties to the IRS.

The practice is called Rollovers as Business Startups (ROBS). The business owner takes his or her tax-deferred retirement funds and uses them to start or buy a business or franchise. The practice is being pitched by several financial companies toward Baby Boomers and others who are looking to start or buy businesses after leaving corporate jobs where they may have amassed 401(k)s and IRAs.

By using a ROBS plan, the would-be business owners are able to tap into their own retirement monies to fund their businesses, without paying taxes or early-withdrawal penalties. The business owner simply forms a new corporation, and rolls the retirement funds over into a new 401(k) in the new corporation. Then the new 401(k) invests in stock in the business owner’s own corporation. The 401(k) money then goes into the business in payment for the stock, giving the business the use of the funds.

As far as the original retirement account is concerned, it is treated as a rollover. Therefore, no taxes or early-withdrawal penalties need to be paid by the business owner.

It’s all perfectly legal.

And clever, right? You use your own money, you don’t have to incur the expense of a bank loan, and you avoid early withdrawal penalties and taxes.

Not so fast. . .there are specific compliance rules for handling ROBS retirement accounts and how you can use the money. Those rules are easily violated and can trip up business owners. For example, the new retirement account must remain a qualified retirement account, which involves administrative responsibilities. If the plan gets disqualified, penalties and taxes could be owed. Also, the funds may not be used to pay a business owner a salary.

The IRS points out in a memo that ROBS aren’t exactly a violation of tax law, but the IRS is making clear that it considers the plans questionable:

“ROBS plans, while not considered an abusive tax avoidance transaction, are questionable in that they may serve solely to benefit one individual’s exchange of tax-deferred assets for currently available funds.”

Two pending lawsuits highlight the disastrous consequences if ROBS plans fall out of compliance. In Peek v Commissioner (PDF), two Colorado entrepreneurs used ROBS retirement funds to guarantee a business loan. The Tax Court said using the funds to guarantee a loan is prohibited, and claims they owe over $500,000 in taxes and penalties. In Ellis v Commissioner (PDF), a Missouri entrepreneur used ROBS money to rent space and pay himself a salary. The IRS says those are also prohibited uses for ROBS funds.

One CPA calls the lawsuits “ticking time bombs.” In an article in The Franchise Times, Steve Hamilton, a certified public accountant with Schmidt and Associates in Cincinnati, is quoted as saying:

“The lawsuits show that the Internal Revenue Service is looking deeply into these transactions. If it blows up, participants can be looking at millions in back taxes and penalties.”

Another concern is that the practice may put entrepreneurs’ retirement security at risk simply because of the high failure rates of businesses. According to the IRS memo issued in January:

“Overall, the research we conducted and the responses we received to the compliance checks indicated that while some of the ROBS were successful, many of the companies in the sample had gone out of business within the first 3 years of operation, experiencing significant monetary loss, bankruptcy, personal and business liens, or had their corporate status dissolved by the Secretary of State (voluntarily or involuntarily).”

Younger entrepreneurs may have enough years to recover from business failure and rebuild their retirement funds. But the ROBS technique is especially risky for older entrepreneurs who face losing their retirement savings at a time when they may no longer be able to recover, if the business fails.

The IRS wants business owners to understand what is involved with complying with ROBS funding plans — and the risks. More at the IRS site.

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I guess they must really do something lest they want people to abuse this. While it may sound great for a business startup, it is still not fair to those people who use tax-incurred money. So I guess this is somewhat inevitable.

Not only does this sound really complicated (we’re dealing with the tax code after all) but it sounds like a large risk. I only hope that people are educating themselves on the risks before doing this.

I saw this posted the other day, and I’ve seen articles like this…ones that mention “Possible IRS scrutiny” coming soon on these ROBS plans.

Maybe the IRS will start taking a harder look at these plans-maybe not.

It’s all about the paperwork. It needs to be done 100% correctly.

Those of you who know me, and have been following me online for the past several years, know that I’m a pretty skeptical soul. What can I tell you? I am what I am.

I’m comfortable with these plans, as long as they’re done right. I’m also comfortable with some people using a portion of their retirement savings to help fund a business.

The scenario needs to be right. 25-year-olds with $12,000 in their IRA-not a good fit for these programs.

50 year old’s with $300k in an IRA, much better. But, they should never dig into their retirement plans too deep. In other words, they shouldn’t use $250k of the $300k they have sitting there. Unless they have other sizeable assets that can be liquidated quickly.

I’ve covered this topic several times in the past, and whenever I do, the comment engine gets pretty fired up. Usually, the comments come from well-meaning accountants who are very risk-averse to begin with, and don’t have all the facts.

The bottom line: ROBS are not for everybody. But, in the right situation, and as long as the IRS is okay with them, I am comfortable using them.

Heck, I’ve had clients decide to use a portion of their retirement funds to start franchises in the past, and have never heard of any problems related to them.

The use of 401k funds to start or buy a business is a viable option given the right situation. However, it should be brought to the attention of small business owners that are considering 401k ROBS business financing that the IRS requires an independent valuation of the 401k invested corporation. Fortunately, these limited scope valuations are relatively inexpensive.

Looking past the Form 5500 reporting requirement, independent valuations, can serve as performance monitoring tool for the management.

Incidentally, the Peek vs Commissioner, confirms that the corporate outside CPA is not independent enough for an acceptable valuation by the IRS.

Hi Joel
You seem to understand the process and maybe you can shed light on my question. I am working for a Startup Company and have invested in the company. I would like to invest more money with my funds in my Qualified Plans. Does this fall under the ROBS classification? I am not an owner, just a regional sales rep.
Thank you, in advance, for your help.

You can’t use ROBS $ to pay on a lease, but you can to buy a franchise. What else can you use the $ for, to buy inventory or to buy a building or real estate for a business? Can one buy a financial advisory business from a retiring advisor?

It looks more like the IRS will need much clearer definitions of what is considered a direct investment, a franchise investment and what is simply someone trying to use a workaround against tax penalties for early withdrawals. The big question I have is what will be defined as a business, a business investment and business assets by the IRS. Meaning, where the internet is concerned. Is there a definition between digital assets or an online business and a more tangible ‘brick and mortar’?

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